EPA’s Crackdown on CO2 Emissions: An Indecent Proposal?

Editor’s Note: Elliott Gue and I will attend the Energy Information Administration’s annual energy conference in Washington, DC, where policymakers and industry participants will share their take on a variety of hot-button issues. We’re particularly looking forward to the panels on US crude-oil exports and renewable energy should provide insight. On July 16, we’ll post an Exclusive Video Report on the conference for Conrad’s Utility Investor subscribers. Not a subscriber? Learn more about the publication and how you sign up for a risk-free trial subscription.

On June 2, 2014, the US Environmental Protection Agency (EPA) proposed new regulations that aim to limit carbon dioxide (CO2) emissions from power plants. CO2 is the greenhouse gas a consensus of scientists believes is responsible for global climate change.

This proposal follows a previous move that placed strict limits on construction of new power plants and effectively ruled out building new coal-fired facilities, unless they’re equipped with as-of-yet untested carbon capture technology.

Investors shouldn’t assume that last month’s announcement is the EPA’s last move to reduce CO2 emissions–or that electric utilities are the only industry in its sights.

The Federal Energy Regulatory Commission ultimately rejected this request, but this move could signal that the EPA will take a more aggressive stance on future LNG export projects.

Regardless of your opinion on global warming, one fact is indisputable: The EPA’s actions have real-life consequences and will create winners and losers.

Although the EPA’s proposed limits on CO2 emissions spell danger for more than a few companies and their investors, they also represent a $100 billion dollar profit opportunity over the next decade.

And investors who look beyond the scary headlines and breathless hype of advocates on both sides of the issue will reap the spoils.

The hyperbole has flowed freely on this issue. Supporters have lauded the EPA’s proposed rules as transformative; those on the short end of the stick have called them catastrophic.

Meanwhile, shortsighted investors wrongly assume that solar power is a can’t-miss proposition and utilities that rely heavily on coal-fired power plants are a dying breed.

The EPA’s Proposal

The EPA’s proposal sets a target of reducing CO2 emissions by 30 from 2005 levels over the next 15 years. Under this plan, individual states would determine how they will meet this goal. Some states face more of an uphill battle than others.

These proposed rules would take effect next year, after a comment period and subsequent modifications. The EPA will begin to monitor states’ progress starting in 2020.

Investors shouldn’t put too much stock in these proposed rules; the final version will differ significantly.

For one, there’s bipartisan opposition to regulating CO2 emissions in Congress. And this opposition will intensify if Republicans tighten their grip on the House of Representatives, take control of the Senate and/or gain power in state legislatures.

President Barack Obama’s allies should retain enough power in Congress to uphold his vetoes, which should prevent successful legislation to restrict the EPA’s actions.

But the next presidential election is only two years away–and there’s no guarantee that the next occupant of the White House will share President Obama’s zeal for cutting CO2 emissions.

Second, the EPA has left enforcing this mandate up to the states, rather than setting clear parameters itself. This flexibility means that a lot of people will have input into how this plays out. And some politicians have vowed to fight the mandate, including Texas’s governor.

Finally, there are the inevitable court challenges. The EPA has precedent on its side; the courts rejected the second Bush administration’s contention that the agency lacked the authority to regulate CO2 emissions. But oftentimes the purpose of a court challenge is merely to delay, not derail, a policy. And the greater the controversy, the more likely implementation will be deferred.

Southern Company: Still a Power Player

Southern Company (NYSE: SO) is the monopoly electricity supplier for much of the Southeast US, including Georgia and Alabama and swathes of Florida and Mississippi.

The company has a well-earned reputation for providing reliable service at some of the lowest rates in the nation. And its relations with regulators are both cordial and cooperative, allowing it to do long-term planning to keep costs low.

This combination has also made Southern Company’s stock a highly reliable wealth builder. I’ve owned the stock since the 1990s and have been well-rewarded by religiously reinvesting dividends year after year.

However, Southern Company is also one of the country’s biggest CO2 emitters, which raises serious questions about whether the stock’s remarkable run will continue in coming years.

The utility has already started making the necessary moves to comply with the EPA’s proposed rules.

In fact, the company has moved in this direction for several years. Thus far, support from local regulators has ensured that Southern Company has recovered its extensive investments while adding to its rate base and earnings.

The company’s two new nuclear reactors at the Vogtle site in Georgia won’t be in service until late 2017 and early 2018.

But the utility has already funded most of these projects, thanks to an automatic rate surcharge that’s allowed investment to be recovered as incurred. This arrangement stands in sharp contrast to when Southern Company wrote off nearly half the cost of Vogtles’s first two reactors in the 1970s and early 1980s.

Nuclear power plants emit no carbon dioxide. And starting up the new Vogtle plants will eliminate many tons of emissions from shuttered coal-fired power plants.

Southern Company has also built a fleet of state-of-the-art gas-fired power plants over the past several years. Some have replaced older coal plants that the company shut down.

As recently as 2008, the firm produced 70 percent of its electricity from coal and 16 percent from natural gas. Today, the utility can generate almost half its power from gas-fired plants.

Equally important, the firm retains the ability to switch back to coal to take advantage of lower costs–a flexibility that paid off when natural gas prices skyrocketed in the first quarter.

The plant will burn cheap lignite coal from a nearby mine, while the sequestered CO2 will be sold to oil producers that will inject the gas into mature wells to enhance their output.

Construction of Kemper has run well over budget, which is hardly surprising for a first mover project. But with Mississippi tasked with cutting its CO2 emissions by 38.8 percent from 2012 levels, opposition to further rate increases to support the state-of-the-art Kemper plant could diminish.

Southern also has a wide range of investments in solar energy, much of it through a joint venture with an investment entity controlled by billionaire Ted Turner. That’s a relatively small part of its generation mix, but it’s another way the company is turning the EPA’s rules on CO2 emissions into a profitable opportunity.

If the EPA’s proposal becomes the law of the land, winners and losers won’t be determined by how much CO2 they produce today. Rather, the distinction will be whether they were able to work with regulators to make needed investments to modify its generation base.

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